Ongoing risks in China

February 2018 | SPOTLIGHT | RISK MANAGEMENT

Financier Worldwide Magazine

February 2018 Issue

Conducting business in any country without doing appropriate homework beforehand can be perilous. Every country has its own set of problems, and that certainly includes the US. But doing business in China, the world’s fastest growing marketplace that matters, without considering the risks, can be fatal for the uninformed. We have witnessed businesses lose billions of dollars due to fraud or theft of intellectual property. In each case, the losses were due to a simple failure – lack of preparation and appreciation for what might happen, and what does happen frequently in China.

So what have we learned about the possible risks for businesses operating in China? First, the Chinese business environment is on steroids. GDP in China continues to outpace every country, and it shows no sign of slowing down in a meaningful way. Much like in the US at certain periods in the last few decades, in China today, entrepreneurs abound and growth continues, but certain practices that cause dismay to businesses remain common. Growth and risk-taking during a period of economic boom often seem to go together with fraud and deception. This is not necessarily a country-specific issue in China, but is symptomatic of the desire of many to ‘get rich quick’ or a ‘fear of losing out’. Everyone in China seems to be opening a factory, starting a business or competing against mature Western companies. The time is now in China, many seem to believe, and both the good guys and the bad guys are out in force.

So, what can possibly go wrong in China if you are a smart Western organisation? When entering the market, senior executives and strategists will survey the landscape. Their business has a great track record of growth, they have a proven external law firm, and they have Mandarin speakers, a great internal audit team and have done some business in China before. They will be prepared. Confidence abounds. Unfortunately, as we have seen time and time again, none of the above will likely prevent a company’s Chinese employees from appropriating its intellectual property by theft or other means (such as counterfeiting, setting up a competing business with the company’s processes, stealing clients and more). Imagine how sophisticated clients in the Fortune 200 feel when learning that their largest vendors in China are owned by their own employees.

China can be a challenging and alarming place to do business. The risks are present regardless of how you enter the country, whether it be through a joint venture, by building a new factory or entering into an agency agreement.

Yet, simple due diligence strategies can prevent many of the above problems, and effective investigative planning can mitigate even the worst scenario. Vendor due diligence is crucial in China; this cannot be overemphasised. And when your hotline report is about vendor fraud or collusion, do not think for a minute that it is not happening. Have a plan to respond quickly and aggressively to reports of vendor and employee collusion, or theft of IP. Both are common problems for organisations active in China.

One obvious potential problem that can be mitigated through diligence is the risk of bribery. Because the government, in all its iterations in China, has its hand in so many commercial activities, one risk for doing business in the country may include violations of the Foreign Corrupt Practices Act, the UK Bribery Act, or even Chinese laws forbidding bribery. Despite Chinese efforts to rein in corrupt officials, bribery is still a common way to achieve a business advantage in the country.

One way that Chinese officials today are being paid illicit funds is through shell companies that are registered in places like the British Virgin Islands (BVI). This simple practice of creating a shell can easily hide the fact that party officials are beneficial owners of businesses. Creating companies in places where you have no obligation to identify the real owners is a global problem, admittedly, and due diligence efforts must root out potential problems.

How can bribery be mitigated? One easy way to avoid this problem is to make sure your accounts payable unit cannot make payments to any jurisdiction where business is not actually occurring, like the BVI. Another way is through due diligence that includes local media research in Mandarin, or sometimes Cantonese. Databases identifying who is and is not a politically-exposed individual are full of holes.

Another common challenge for Western companies doing business in China is the proliferation of kickback schemes involving employees and vendors. It is simple to create a shell vendor that disguises ownership, enabling employees to be on both sides of a relationship. A simple kickback scheme may see an employee with procurement responsibilities create a shell company which is approved as a vendor. Protocols are followed and the vendor is easily approved. Even the employer’s internal audit team would find no problems – bids are in place and goods and services are being provided.

Employees often create bogus vendor organisations. These companies, sometimes owned by other shell companies or friends or family members, pose as legitimate vendors. Unless due diligence and internal controls are very good and are appropriate for China, it is quite easy for employees to use these shells to defraud their employers. Many shells are simply ‘pass throughs’ – the vendors are just brokers that charge twice as much as the market dictates for goods and services. One reason that this happens so frequently in China is that due diligence on vendors is often only seen as a ‘check-the-box’ exercise.

If due diligence on a prospective vendor is limited to research of watch or sanctions lists, or to assess whether someone is on a list of politically exposed persons, then the bad guys have already beaten the system. This approach will not be even slightly effective in China as a methodology to fight fraud and prevent corruption.

The effective approach to due diligence in China must include research of local media, site visits to verify operations and interviews of industry sources.

Finally, whether doing business in China, or elsewhere, it is easy to fabricate information to deceive others. We have found that in China, it is easy for an ambitious person to beat the internal controls of major Western companies. It is very easy to falsify information, and for bright people to defraud businesses, especially when they are not aware of the prevalent schemes that pervade the Chinese landscape.

At the end of the day, China is a robust economy, growing, changing and dynamic. But failure to be prepared to operate in the environment has caused organisations to lose billions of dollars in profits to fraud and mischief. The good news is that there are cost-effective ways to perform diligence and investigations that can mitigate risk and save hard-earned dollars.

Jeffrey Klink is president and chief executive of Klink & Co., Inc. He can be contacted on +1 (412) 201 9123 or by email: jklink@klink-co.com.